As fiscal cliff nears, market complacency sets in

Written by Reuters | New York | Updated: Dec 11 2012, 08:25am hrs
Like many on Wall Street, investor Todd Petzel cringed when US treasury secretary Timothy Geithner said this past Wednesday that he was ready to let the economy go over the fiscal cliff if Republicans would not agree to higher tax rates on the rich.

I didnt think good things would come out of the comment, said Petzel, the chief investment officer at Offit Capital Advisors in New York. But nothing happened.

The rhetoric heated up again on Friday, when Republican House Speaker John Boehner accused US President Barack Obama of slow-walking the economy to the edge of the cliff. Again, markets brushed it off and showed very little reaction.

Investors collective shrug marks a stark change from how they had behaved in the two weeks after the presidential election, when nearly every utterance from a politician about the looming budget crisis caused wild swings in stock prices.

The S&P 500 index has nearly retraced the 5.3% slide it suffered in the first seven sessions after the November 6 vote. Some of the rebound reflects market confidence that Democrats and Republicans, despite their rhetoric, will eventually agree on at least a short-term deal to avoid the cliff - nearly $600 billion of tax increases and spending cuts set to take effect in January that could bring on a new recession.

It also could be that investors have peered over the cliff and realised they are looking at a gentle slope instead. The sentiment has definitely changed, said Andrew Wilkinson, chief economic strategist at Miller Tabak & Co in New York. The market has become somewhat desensitised to headlines out of Washington because the fear of the economy hitting a wall in 2013 if we dont get a deal done has diminished.

While the S&P 500 was on track to end the first week of December nearly flat, performance throughout November was far more volatile, with the index lurching from a loss of more than 2% one week to a gain of more than 3% the next. The benchmark ended the month 0.3% higher.

Seasoned investors know that waiting on the sidelines for clarity about fiscal negotiations is not an option, Carmine Grigoli, chief investment strategist at Mizuho Securities, wrote this week in a note to clients.

In our view, the worst case outcomes are likely to be avoided and the stock market should rise by 5% to 7%once the risk of fiscal Armageddon is behind us.

Not everyone is brushing off the risks entirely. Investors could be too sanguine and the end of the year could come without a deal. The market could yet lurch downward, repeating the big sell-offs that occurred during the 2011 debt ceiling talks.

But while chief executives have complained that not knowing what future taxes will be has suppressed investment and hiring, some investors say lawmakers still have time in early 2013 to strike a deficit-reduction deal without imperiling the economy.

Michael Fredericks, lead manager of the BlackRock Multi-Asset Income Fund, said the recent malaise may simply be a little bit of fatigue setting in. This short-termism and parsing the language that comes out of the mouths of politicians is getting a little old. People are stepping back and saying: How can I possibly make an investment decision based on the next press release or TV appearance by the latest senior Republican or Democrat

One indicator of the markets reduced concern is the defense sector, which will be hit hard if the spending cuts take effect. The PHLX Defense Sector Index is up 13% for the year, and sits just a few points from a yearly high.